Solution to some exercises on Bertrand duopoly

Question 1 The demand curve is given by Q = 20 − p if p < 20 and Q = 0 if p ≥ 20. Both firms
have the same constant unit cost 4.

Question 1(a) Determine the profit functions of firms 1,2.

Solution: Denote by D1, D2 the demands received by firms 1,2.

If p1 < p2 (firm 1's price is the minimum of the two), then firm 2 receives zero demand; firm 1
receives the full demand at price p1. Therefore D2 = 0 and D1 = (Q at price p1), so D1 = 20 − p1 if
p1 < 20 and D1 = 0 if p1 ≥ 20.

If p1 > p2 (firm 2's price is the minimum of the two), then firm 1 receives zero demand; firm 2
receives the full demand at price p2. Therefore D1 = 0 and D2 = (Q at price p2), so D2 = 20 − p2 if
p2 < 20 and D2 = 0 if p2 ≥ 20.

If p1 = p2 = p (both firms set the same price p), then each firm receives half of the demand at
price p. Therefore D1 = D2 = (1/2)*(Q at price p), so D1 = D2 = (20 − p)/2 if p < 20 and D1 = D2 =
0 if p ≥ 20.

The profit of firm 1 is π1= Total revenue of firm 1− total cost of firm 1
= p1*D1 − 4*D1 = (p1 − 4)D1
Note that D1 depends on both p1 and p2. So the profit of firm 1 depends on both p1 and p2.

The profit of firm 2 is π2= Total revenue of firm 2− total cost of firm 2
= p2*D1 − 4*D1 = (p2 − 4)D2
Note that D2 depends on both p1 and p2. So the profit of firm 2 depends on both p1 and p2.

Questions 1(b)-1(e)

It will be useful to look at the profit of a monopolist (a single seller) who faces the same demand

Q = 20 − p if p < 20 and Q = 0 if p ≥ 20

and who has the same constant unit cost 4. If the monopolist sets price p, it obtains profit π = its
total revenue − its total cost = p*Q − 4*Q = (p − 4)Q. Using the expression of Q from above

π = (p − 4)(20 − p) if p < 20 and π = 0 if p ≥ 20

 Figure 1

profit

monopolist's profit

half of monopolist's
profit

0 4 pM = 12 20 p (price)

The red curve in Figure 1 presents the monopolist's profit π. It equals zero at p = 4 and at p = 20.
The profit continues to be zero for p > 20. When p < 4 (price is below the unit cost), the profit is
negative. Between p = 4 and p = 20, the profit is inverse u-shaped. Its maximum is attained at the
mid-point between 4 and 20, which is (4 + 20)/2 = 12. Therefore the monopoly price pM (the
price that maximizes monopolist's profit) equals 12.

The blue curve above presents half of monopolist's profit. These two curves will be useful for the
Bertrand duopoly. This is because when two firms set different prices, the firm that sets the
minimum price obtains the monopolist's profit at its price (which can be found from the red
curve). When two firms set the same price, each obtains half of the monopolist's profit at its price
(which can be found from the blue curve).

Question 1(b) Find best response of firm 2 to p1 = 6.

Solution: Fix p1 = 6. If firm 2 sets any p2 < 6, it receives the full demand at that price and obtains
the monopolist's profit (red curve of Figure 1). If firm 2 sets any p2 > 6, it receives zero demand
and its profit is also zero. If firm 2 sets p2 = p1 = 6, it receives half of the demand at price 6 and
so its profit is half of monopolist's profit (blue curve of Figure 1). As profit falls by half at p2 = 6
 and then again falls to zero for p2 > 6, the profit function has two "jumps" at price 6. Using this
information, firm 2's profit as a function of its price p2 is drawn below.

Figure 1(b)

firm 2's profit when p1 = 6

jump
firm 2's profit for p2 < 6

firm 2's profit for p2 = 6

jump

0 6 p2

firm 2's profit for p2 > 6

We can observe from Figure 1(b) that firm 2's profit is not maximum at any p2 > 6, so setting
such a price is not a best response. As firm 2's profit is increasing for p2 < 6, no such p2 is a best
response (for any price lower than 6, firm 2 can have a higher profit by setting a price slightly
higher but still lower than 6). Setting p2 = 6 is also not a best response, since at p2 = 6 its profit
falls by half (firm 2 can do better by setting a price slightly lower than 6). This shows that firm 2
does not have a best response to p1 = 6.

Question 1(c) Find best response of firm 1 to p2 = 4.

Solution: Fix p2 = 4. If firm 1 sets any p1 < 4, it receives the full demand at that price and obtains
the monopolist's profit (red curve of Figure 1). If firm 1 sets any p2 > 4, it receives zero demand
and its profit is also zero. If firm 1 sets p1 = p2 = 4, it receives half of the demand at price 4;
however, since firm 1's unit cost is 4, regardless of the demand it receives, it obtains zero profit if
it sets p1 = 4. Using this information, firm 1's profit as a function of its price p1 is drawn in the
next figure.
 Figure 1(c)

firm 1's profit when p2 = 4

firm 1's profit for p1 = 4

0 4 p1

firm 1's profit for p1 > 4

firm 1's profit for p1 < 4

We can observe from Figure 1(c) that firm 1 obtains negative profit at any p1 < 4, it obtains zero
profit at p1 = 4 and it also obtains zero profit at any p1 > 4. Therefore, when p2 = 4, the maximum
profit that firm 1 can obtain is zero and this zero profit is attained at p1 = 4 as well as any p1 > 4.
This shows that firm 1 has multiple best responses to p2 = 4: setting any p1 ≥ 4 is a best response.

Question 1(d) Show that (p1 = 4, p2 = 4) is a Nash Equilibrium (NE) of the Bertrand duopoly.

Solution: (p1 = 4, p2 = 4) is an NE if the following two conditions hold:

(i) p1 = 4 is a best response of firm 1 to firm 2's price p2 = 4;

(ii) p2 = 4 is a best response of firm 2 to firm 1's price p1 = 4.

From part (c) we know that p1 = 4 is a best response of firm 1 to firm 2's price p2 = 4 (firm 1 has
multiple best responses to p2 = 4, but in particular p1 = 4 is a best response). So condition (i)
holds.

Since the two firms are symmetric, switching the roles of 1 and 2 it follows that p2= 4 is a best
response of firm 2 to firm 1's price p1 = 4. So condition (ii) also holds.

Since both conditions (i) and (ii) hold, we conclude that (p1 = 4, p2 = 4) is an NE.
 Question 1(e) Show that (p1 = 8, p2 = 8) is a not an NE of the Bertrand duopoly.

Solution: (p1 = 8, p2 = 8) is an NE if the following two conditions hold:

(i) p1 = 8 is a best response of firm 1 to firm 2's price p2 = 8;

(ii) p2 = 8 is a best response of firm 2 to firm 1's price p1 = 8;

To show that (p1 = 8, p2 = 8) is not an NE, it is enough to show that one of the conditions (i)-(ii)
does not hold. In what follows, we show condition (i) does not hold. To see this, fix p2 = 8. If
firm 1 sets any p1 < 8, it receives the full demand at that price and obtains the monopolist's profit
(red curve of Figure 1). If firm 1 sets any p1 > 8, it receives zero demand and its profit is also
zero. If firm 1 sets p1 = p2 = 8, it receives half of the demand at price 8 and so its profit is half of
monopolist's profit (blue curve of Figure 1). As profit falls by half at p1 = 8 and then again falls
to zero for p1 > 8, the profit function has two "jumps" at price 8. Using this information, firm 1's
profit as a function of its price p1 is drawn below.

Figure 1(e)

firm 1's profit when p2 = 8

jump
firm 1's profit for p1 < 8

firm 1's profit for p1 = 8

jump

0 8 p1

firm 1's profit for p1 > 8

We can observe from Figure 1(e) that firm 1 does not have a best response to firm 2's price p2 =
8. Condition (i) is therefore violated, which shows (p1 = 8, p2 = 8) is not an NE.
 Question 2 The demand curve is given by Q = 16 − p if p < 16 and Q = 0 if p ≥ 16. Both firms
have the same constant unit cost 2.

Question 2(a) Determine the profit functions of firms 1,2.

Solution: Denote by D1, D2 the demands received by firms 1,2.

If p1 < p2, then D2 = 0 and D1 = (Q at price p1), so D1 = 16 − p1 if p1 < 16 and D1 = 0 if p1 ≥ 16.

If p1 > p2, then D1 = 0 and D2 = (Q at price p2), so D2 = 16 − p2 if p2 < 16 and D2 = 0 if p2 ≥ 16.

If p1 = p2 = p, then D1 = D2 = (1/2)*(Q at price p), so D1 = D2 = (16 − p)/2 if p < 16 and D1 = D2 =

0 if p ≥ 16.

The profit of firm 1 is π1 = (p1 − 2)D1 and the profit of firm 2 is π2 = (p2 − 2)D2

Question 2(b)-2(d) It will be useful to look at the profit of a monopolist (a single seller) who
faces the same demand

Q = 16 − p if p < 16 and Q = 0 if p ≥ 16

and who has the same constant unit cost 2. If the monopolist sets price p, it obtains profit π =
(p − 2)Q. Using the expression of Q above

π = (p − 2)(16 − p) if p < 16 and π = 0 if p ≥ 16

Figure 2
profit

monopolist's profit

half of monopolist's
profit

0 2 pM = 9 16 p (price)
 The red curve in Figure 2 presents the monopolist's profit π. It equals zero at p = 2 and at p = 16.
The profit continues to be zero for p > 16. When p < 2 (price is below the unit cost), the profit is
negative. Between p = 2 and p = 16, the profit is inverse u-shaped. Its maximum is attained at the
mid-point between 2 and 16, which is (2 + 16)/2 = 9. Therefore the monopoly price pM (the price
that maximizes monopolist's profit) equals 9. The blue curve presents half of monopolist's profit.

Question 2(b) Find best response of firm 2 to p1 = 10.

Solution: Fix p1 = 10. If firm 2 sets any p2 < 10, it receives the full demand at that price and
obtains the monopolist's profit (red curve of Figure 1). If firm 2 sets any p2 > 10, it receives zero
demand and its profit is also zero. If firm 2 sets p2 = p1 = 10, it receives half of the demand at
price 6 and so its profit is half of monopolist's profit (blue curve of Figure 1). As profit falls by
half at p2 = 10 and then again falls to zero for p2 > 10, the profit function has two "jumps" at price
6. Using this information, firm 2's profit as a function of its price p2 is drawn below.

Figure 2(b)

firm 2's profit when p1 = 10

firm 2's profit for p2 < 10

jump

maximum firm 2's profit for p2 = 10

profit
jump

0 pM = 9 10 p2

firm 2's profit for p2 > 10

We can observe from Figure 2(b) that although firm 2's profit has jumps at price 10, they do not
have any effect on determining best response. If firm 2 was the only seller (monopolist), it would
 set price equal to pM = 9 that maximizes monopolist profit. Since firm 1 sets p1 = 10 > 9, firm 2
can set the monopoly price 9, receive the full demand and obtain the maximum profit. Therefore
the only best response of firm 2 to p1 = 10 is to set p2 = 9 (the monopoly price).

Question 2(c) Show that (p1 = 10, p2 = 9) is a not an NE of the Bertrand duopoly.

Solution: (p1 = 10, p2 = 9) is an NE if the following two conditions hold:

(i) p1 = 10 is a best response of firm 1 to firm 2's price p2 = 9;

(ii) p2 = 9 is a best response of firm 2 to firm 1's price p1 = 10;

To show that (p1 = 10, p2 = 9) is not an NE, it is enough to show that one of the conditions (i)-(ii)
does not hold. We know from the previous question that condition (ii) holds. So consider
condition (i). In what follows, we show condition (i) does not hold. To see this, fix p2 = 9. If firm
1 sets any p1 < 9, it receives the full demand at that price and obtains the monopolist's profit (red
curve of Figure 2). If firm 1 sets any p1 > 9, it receives zero demand and its profit is also zero. If
firm 1 sets p1 = p2 = 9, it receives half of the demand at price 9 and so its profit is half of
monopolist's profit (blue curve of Figure 1). The profit function has two "jumps" at price 9.
Using this information, firm 1's profit as a function of its price p1 is drawn below.

Figure 2(c)

firm 1's profit when p2 = 9

firm 1's profit for p1 < 9

jump

firm 1's profit for p1 = 9

jump

0 9 10 p1

firm 1's profit for p1 > 9

 We can observe from Figure 2(c) that p1 = 10 is not a best response to p2 = 9. Condition (i) is
therefore violated, which shows (p1 = 10, p2 = 9) is not an NE.

Question 2(d) Show that (p1 = 2, p2 = 2) is an NE of the Bertrand duopoly.

Solution: (p1 = 2, p2 = 2) is an NE if the following two conditions hold:

(i) p1 = 2 is a best response of firm 1 to firm 2's price p2 = 2;

(ii) p2 = 2 is a best response of firm 2 to firm 1's price p1 = 2.

Since firms are symmetric, it is enough to verify condition (i). Fix p2 = 2. If firm 1 sets any p1 <
2, it receives the full demand at that price and obtains the monopolist's profit (red curve of Figure
2). If firm 1 sets any p2 > 2, it receives zero demand and its profit is also zero. If firm 1 sets p1 =
p2 = 2, it receives half of the demand at price 2; however, since firm 1's unit cost is 2, regardless
of the demand it receives, it obtains zero profit if it sets p1 = 2. Using this information, firm 1's
profit as a function of its price p1 is drawn below.

Figure 2(d)

firm 1's profit when p2 = 2

firm 1's profit for p1 = 2

0 2 p1

firm 1's profit for p1 > 2

firm 1's profit for p1 < 2

We can observe from Figure 2(d) that firm 1 has multiple best responses to p2 = 2: setting any p1
≥ 2 is a best response. In particular, setting p1 = 2 is a best response of firm 1 to p2 = 2. This
 shows that condition (i) holds. It can be similarly shown that condition (ii) holds. This shows (p1
= 2, p2 = 2) is an NE.

Question 3 The demand curve is given by Q = 10 − p if p < 10 and Q = 0 if p ≥ 10. Both firms
have the same constant unit cost 2.

Question 3(a) Determine the profit functions of firms 1,2.

Solution: Denote by D1, D2 the demands received by firms 1,2. If p1 < p2, then D2 = 0 and D1 =
(Q at price p1), so D1 = 10 − p1 if p1 < 10 and D1 = 0 if p1 ≥ 10.

If p1 > p2, then D1 = 0 and D2 = (Q at price p2), so D2 = 10 − p2 if p2 < 10 and D2 = 0 if p2 ≥ 10.

If p1 = p2 = p, then D1 = D2 = (1/2)*(Q at price p), so D1 = D2 = (10 − p)/2 if p < 10 and D1 = D2 =

0 if p ≥ 10.

The profit of firm 1 is π1 = (p1 − 2)D1 and the profit of firm 2 is π2 = (p2 − 2)D2

Question 3(b)-3(d) It will be useful to look at the profit of a monopolist (a single seller) who
faces the same demand: Q = 10 − p if p < 10 and Q = 0 if p ≥ 10 and who has the same constant
unit cost 2. If the monopolist sets price p, it obtains profit π = (p − 2)Q. Using the expression of
Q above π = (p − 2)(10 − p) if p < 10 and π = 0 if p ≥ 10

Figure 3
profit

monopolist's profit

half of monopolist's
profit

0 2 pM = 6 10 p (price)
 The red curve in Figure 3 presents the monopolist's profit π. It equals zero at p = 2 and at p = 10.
The profit continues to be zero for p > 10. When p < 2 (price is below the unit cost), the profit is
negative. Between p = 2 and p = 10, the profit is inverse u-shaped. Its maximum is attained at the
mid-point between 2 and 10, which is (2 + 10)/2 = 6. Therefore the monopoly price pM (the price
that maximizes monopolist's profit) equals 6. The blue curve presents half of monopolist's profit.

Question 3(b) Find best response of firm 1 to p2 = 4.

Solution: Fix p2 = 4. If firm 1 sets any p1 < 4, it receives the full demand at that price and obtains
the monopolist's profit (red curve of Figure 3). If firm 1 sets any p1 > 4, it receives zero demand
and its profit is also zero. If firm 1 sets p1 = p2 = 4, it receives half of the demand at price 4 and
so its profit is half of monopolist's profit (blue curve of Figure 3). As profit falls by half at p1 = 4
and then again falls to zero for p2 > 4, the profit function has two "jumps" at price 4. Using this
information, firm 1's profit as a function of its price p1 is drawn below.

Figure 3(b)

firm 1's profit when p2 = 4

jump
firm 1's profit for p1 < 4

firm 1's profit for p1 = 4

jump

0 4 p1

firm 1's profit for p1 > 4

We can observe from Figure 3(b) that firm 1's profit is not maximum at any p1 > 4, so setting
such a price is not a best response. As firm 1's profit is increasing for p1 < 4, no such p1 is a best
response (for any price lower than 4, firm 1 can have a higher profit by setting a price slightly
higher but still lower than 4). Setting p1 = 4 is also not a best response, since at p1 = 4 its profit
 falls by half (firm 1 can do better by setting a price slightly lower than 4). This shows that firm 1
does not have a best response to p2 = 4.

Question 3(c) Find best response of firm 2 to p1 = 1.

Solution: Fix p1 = 1. If firm 2 sets any p2 < 1, it receives the full demand at that price and obtains
the monopolist's profit (red curve of Figure 1). If firm 2 sets any p2 > 1, it receives zero demand
and its profit is also zero. If firm 2 sets p2 = p1 = 1, it receives half of the demand at price 1 and
so its profit is half of monopolist's profit (blue curve of Figure 1). Here the profit function has
two "jumps" at price 1. Using this information, firm 2's profit as a function of its price p2 is
drawn below.

Figure 3(c)

firm 2's profit when p1 = 1

firm 2's profit for p2 > 1 (zero profit)

0 jump p2
firm 2's profit for p2 = 1 (negative profit)
jump

firm 2's profit for p2 < 1 (negative profit)

We can observe from Figure 3(c) in this case jumps in the profit function do not affect best
response of firm 2. For p2 = 1 or any p2 < 1, firm 2 obtains negative profit (since price in these
 cases is below its unit cost). For any p2 > 1, firm 2 obtains zero profit. Therefore firm 2 has
multiple best responses to p1 = 1: any p2 > 1 is a best response.

Question 3(d) Show that (p1 = 3, p2 = 5) is a not an NE of the Bertrand duopoly.

Solution: (p1 = 3, p2 = 5) is an NE if the following two conditions hold:

(i) p1 = 3 is a best response of firm 1 to firm 2's price p2 = 5;

(ii) p2 = 5 is a best response of firm 2 to firm 1's price p1 = 3;

To show that (p1 = 3, p2 = 5) is not an NE, it is enough to show that one of the conditions (i)-(ii)
does not hold. In what follows, we show condition (ii) does not hold. To see this, fix p1 = 3. If
firm 2 sets any p2 < 3, it receives the full demand at that price and obtains the monopolist's profit
(red curve of Figure 3). If firm 2 sets any p2 > 3, it receives zero demand and its profit is also
zero. If firm 2 sets p2 = p1 = 3, it receives half of the demand at price 3 and so its profit is half of
monopolist's profit (blue curve of Figure 1). The profit function has two "jumps" at price 3.
Using this information, firm 2's profit as a function of its price p2 is drawn below.

Figure 3(d)
firm 2's profit when p1 = 3

jump
firm 2's profit for p2 < 3
firm 2's profit for p2 = 3
jump

0 p2
3 5

firm 2's profit for p2 > 3

We can observe from Figure 3(d) that p2 = 5 is not a best response to p1 = 3. Condition (ii) is
therefore violated, which shows (p1 = 3, p2 = 5) is not an NE.